One of these days, you’re going to wake up one morning and discover why we and a few other outlets seem so hell-bent on talking incessantly about China’s deleveraging efforts.
We’ve penned dozens of posts about this over the past four weeks or so (latest here). Indeed, we’ve spilled so much digital ink on it that you’d be forgiven for thinking we’re overdoing it or otherwise overstating the case.
But while you’d be forgiven, you’d be wrong. And decisively so.
One of the key things to understand about the shadow banking unwind in China is that it’s impossible to understand. And no, there aren’t any typos in there. Here’s how we put it earlier this weekend:
Setting aside the obvious implications for the global credit impulse, the problem with squeezing China’s shadow banks is that there’s really no telling where the credit extended via those channels ended up. Which means that when you turn the screws by tightening and by refusing to roll over maturing liquidity facilities, crazy shit has a habit of just popping up out of the blue in places you might not have expected. So you get things like collapsing iron ore prices or the 5s10s curve inverting.
That’s critical. All we know for sure is that shadow credit fuels speculation, but we can only get a read on where the speculating is happening after the fact. That is: after a bubble has already been inflated somewhere. Worse, in some cases we don’t even find out until after a bubble has burst, because it’s not always easy to determine whether price action in this or that asset emanates from speculation or whether it’s “honest” (so to speak).
And then there’s the fact that the very nature of WMPs (the most worrisome shadow bank ticking time bomb of them all) makes them problematic. Recall what we said back in March in a post called “‘Is There A Problem We’re Not Seeing?’ – China’s Banking System Reaches ‘Tipping Point’“:
A new Macro Prudential Assessment framework which contains stricter oversight into banks’ off-balance-sheet activities, including the sale of wealth management products is part and parcel of the sweeping effort to rein in shadow banking. But that very same labyrinthine shadow banking complex serves as a credit creation and risk repackaging machine and is in many cases the only means by which borrowers who have lost access to traditional channels can obtain credit. Wealth management products (which are a maturity-mismatched nightmare) are a spoke on that wheel.
Note the bolded bit. Specifically the part about WMP’s being a “maturity-mismatched nightmare.”
See, these things have to be rolled every couple of months, but the assets the paper finances don’t mature for years. So what happens if you can’t roll the paper? Well, the fucking market freezes, that’s what. This is precisely like what happened in the lead up to the collapse of the Canadian ABCP market in 2007.
Well with all of that in mind, consider the following commentary out recently from SocGen.
Banks, thanks to their extensive client outreaches, attract household and corporates to invest in WMPs managed by themselves and/or NBFIs. After expanding more than nine fold between 2010 and 2015, the outstanding of bank WMPs increased another 25% in 2016 to CNY29tn (Chart 2), and less than 20% of that is allocated to bank deposits and reflected on banks’ balance sheet (Chart 3). In addition, NBFIs manage CNY80tn in various forms of wealth management businesses, the main funding of which is probably from banks, on-balance-sheet (“equity and other investments” or “investments in market securities”) as well as off-balance sheet (bank WMPs). Excluding possible double-counting and holding of government bonds, the total outstanding of the shadow banking activities related to the two approaches above was probably still close to 80% of GDP (~CNY60tn) at end-2016, after being only a minor segment of the financial system not even ten years ago.
Chinese authorities are right to take action, since the development of shadow banking and banks’ deep involvement is posing increasingly grave risks to the entire system. The various defaults or near-defaults in the fixed income market in the past few months were clear indications of how vulnerable small banks and NBFIs – the more aggressive players in shadow banking businesses – have become to any liquidity tension. The common traits of those default incidents are high leverage, duration mismatch and complex cross-holding structures, which are also the main targets of regulators.
- Rising financial leverage Although there is no one comprehensive measure of financial leverage, we can spot the increasing vulnerability of the system in a number places. Most notably, banks’ balance sheets, especially those of small banks, have been growing much faster than the economy, household and corporate deposits, and credit to the nonfinancial sector. And a large part of the rampant growth of small banks has been funded by interbank liquidity and short-dated debt instruments, notably NCDs. With regards to banks’ off-balance-sheet wealth management businesses, it is not uncommon for NBFIs to add leverage to the portfolio handed over from the banks for them to manage. NBFIs can also tap the interbank market for short-term funding, which used to be quite cheap before the PBoC started tightening liquidity in 3Q16.
- Chronic duration mismatch Banks’ overall reliance on short-term funding has been rising, also due to the aggressive expansion of bank WMPs. Over half of bank WMPs are of duration shorter than six months, although their expected returns are often 200bp above ordinary bank deposits. However, the average maturity of Chinese onshore bonds, which account for at least half of banks’ on-balance-sheet non-lending investments and off-balance-sheet WMPs’ underlying assets (Chart 3), is three to four years. There is also significant investment in so-called nonstandard assets, which are often project financing and of private-equity nature. They are probably still more illiquid than bonds.
- Mind-boggling cross-holdings As we alluded to above, banks often hand over some of their on-balance-sheet and WMP portfolio to third-parties (NBFIs) to manage for convenience and/or higher returns. And NBFIs sometimes pass on some part of this money to yet other counterparties that can be more risk-loving. Therefore, there exists a significant amount and a complex web of cross-holdings between banks and NBFIs as well as among NBFIs. Consequently, it is nearly impossible to have a clear idea who is responsible for what when things go wrong. The danger is that since banks are the ones directly facing the mass market of retail investors, they may be cornered to internalise most of the credit risk at the end of the day